A history of central banking in great britain and the united states

A History of Central Banking in Great Britain and the United States Central banks in Great Britain and the United States arose early in the financial revolution.. His earlier studies of

A History of Central Banking in Great Britain

and the United States

Central banks in Great Britain and the United States arose early in the financial revolution The Bank of England was created in 1694, whereas the first banks of the United States appeared during 1791-

1811 and 1816-36 and were followed by the Independent Treasury, formed from 1846 to 1914 These institutions, together with the Suffolk Bank and the New York Clearing House, exercised important central banking functions before the creation of the Federal Reserve System

in 1913 Significant monetary changes in the lives of these British and American institutions are examined within a framework that deals with the knowledge and behavior of central bankers and their interactions with economists and politicians Central bankers' behavior has shown considerable continuity in the influence of incentives and their inter-est in the stability of the financial markets For example, the Federal Reserve's behavior during the Great Depression and the periods of low inflation of the 1990s and its resurgence the next decade follow from its structure and from government pressures rather than from accidents of personnel

John H Wood is R J Reynolds Professor of Economics at Wake Forest University, Winston-Salem, North Carolina He has also taught

at the Universities of Birmingham, Pennsylvania, and Singapore and at Northwestern University A Life Fellow of Clare Hall, Cambridge, and

a Visiting Fellow of the American Institute for Economic Research, Professor Wood has also been a full-time or visiting economist at the Federal Reserve Board and the Federal Reserve Banks of Chicago, Dallas, and Philadelphia His earlier studies of central banking include

in 1967 the first application of the theory of economic policy to Federal Reserve behavior Professor Wood's research has appeared in leading journals such as the American Economic Review, Journal of Political Economy, Quarterly Journal of Economics, Journal of Finance, and Journal of Monetary Economics

STUDIES IN MACROECONOMIC HISTORY

SERIES EDITOR: Michael D Bordo, Rutgers University

EDITORS: Forrest Capie, City University Business School, London

Barry Eichengreen, University of California, Berkeley

Nick Crafts, London School of Economics

Angela Redish, University of British Columbia

The titles in this series investigate themes of interest to economists and nomic historians in the rapidly developing field of macroeconomic history The four areas covered include the application of monetary and finance the-ory, international economics, and quantitative methods to historical problems; the historical application of growth and development theory and theories of business fluctuations; the history of domestic and international monetary, financial, and other macroeconomic institutions; and the history of inter-national monetary and financial systems The series amalgamates the former Cambridge University Press series Studies in Monetary and Financial History

eco-and Studies in Quantitative Economic History

Other books in the series:

Howard Bodenhorn, A History of Banking in Antebellum America

Michael D Bordo, The Gold Standard and Related Regimes

Michael D Bordo and Forrest Capie ( eds ), Monetary Regimes in Transition

Michael D Bordo and Roberto Cortes Conde ( eds ), Transferring Wealth and Power from the Old to the New World

Claudio Borio, Gianni Toniolo, and Piet Clement ( eds ), Past and Future of Central Bank Cooperation

Richard Burdekin and Pierre Siklos ( eds ), Deflation: Current and Historical Perspectives

Trevor J 0 Dick and John E Floyd, Canada and the Gold Standard

Barry Eichengreen, Elusive Stability

Barry Eichengreen (ed.), Europes Postwar Recovery

Caroline Fohlin, Finance Capitalism and Germanys Rise to Industrial Power Continued after the index

A History of Central Banking in Great Britain

and the United States

JOHN H WOOD

Wake Forest University

MCAMBRIDGE

Singapore, Sao Paulo Delhi, Tokyo, Mexico City

Cambridge University Press

32 Avenue of the Americas, New York, NY TOOI3-2473, USA

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©john H Wood 2.005 This publication is in copyright Subject to statutory exception

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Wood, john H (john Harold)

A history of central banking in Great Britain and the United States I John H Wood

p em.- (Studies in macroeconomic history) Includes bibliographical references and index

ISBN o-521-85013-4 (hardcover)

1 Banks and banking, Central - Great Britain - History 2 Bank of England - History 3· Monetary policy- Great Britain- History 4· Banks and banking, Central- United States- History 5· Board of Governors of the Federal Reserve System (U.S.)- History

6 Monetary policy - United States - History I Title II Series

HG2994.W66 2005

332 1' I 0941-dC22 2.00402.4984

ISBN 978-o-521-85013-I Hardback

ISBN 978-0-521-74131-6 Paperback Cambridge University Press has no responsibility for the persistence or accuracy of URLs for external or third-party Internet Web sites referred to in this publication and docs not guarantee that any content on such Web sites is,

or will remain, accurate or appropriate

To Norma, as always

could always govern its value But the currency was left entirely under the management and control of a company of merchants - individuals, he was most ready to admit, of the best character, and actuated by the best intentions; but who, nevertheless, did not acknowledge the true princi-ples of the currency, and who, in fact, in his opinion, did not know anything about it

David Ricardo, House of Commons, June 12, 1822

(N)o semblance of acquisitiveness prompts (the Federal Reserve Board's) operations; no banking interest is behind, and no financial interest can pervert

or control it It is an altruistic institution, a part of the Government itself, representing the American people, with powers such as no man would dare misuse

Carter Glass, House of Representatives, September 10, 1913

Contents

1 Understanding Central Bankers and Monetary Policy 1

War Inflation Suspension, and More Inflation 1793-1810 9 The Bullion Committee and the Macroeconomic

Banking, Central Banking Knowledge, and Incentives to the

Rhetoric, Knowledge and Monetary Policy 27

4 Making a Central Bank: II Looking for a Rule 60

5 Making a Central Bank: III Means and Ends 89

Conclusion: Central Banking under the Gold Standard 113

ix

6 Central Banking in the United States, 1790-1914 117

The First and Second Banks of the United States, 1791-1836 123 Money Centers and Clearinghouses, 1853-1913 134

TheindependentTreasur~1846-1914 139

7 Before the Crash: The Origins and Early Years of the Federal

Another Way: Keynes's Plan for a State Bank for India 166

Regulating Credit: Interest Rates or Discrimination? 176

A Model of Monetary (Credit) Policy? The Federal Reserve

Conflicts in the Federal Reserve System 189 Federal Reserve Knowledge and Incentives on the Eve

8 The Fall and Rise of the Federal Reserve, 1929-1951 194

Riding the Tiger: Marriner Eccles, the Federal Reserve,

9 Central Banking in the United States after the Great

Norman's Bank and the Return to Gold in 1925 280 The American Loan and the Resumption of 1947 293 Monetary Policy, 1945-1960: From Cheap Money to Stop-Go 297 The Bank, Prime Ministers, and the Pound: From One

From Radcliffe to Competition and Credit Control 323

Interest Rules: Tooke, Wicksell, and the Quantity Theory 330

Econometrics and the Theory of Economic Policy 340

Contents xi

Monetary Policy with a Floating Exchange Rate August 1971

2.1 Bank of England notes and deposits, the rate of exchange on

Hamburg, and the price level, 1790-1825

6.1 Position of the Second Bank of the United States

6.2 Money, the dollar value of gold, the price level, and real GNP,

8.1 Real GNP, price level, money supply, the prime commercial

paper rate, and the Federal Reserve Bank of New York

discount rate

8.2 Excess reserves and borrowings, 1929-84

8.3 Yields on U.S T bills and long-term bonds, 1941-60

9.1 Operation Twist: Treasury yield curves, January averages,

1961-65

9 2 Gold value, production, and official reserves,

1800 1999

10.1 Bank rate, unemployment, dollar value of sterling, and U.K

and U.S price levels, 1913-38

10.2 Bank rate, inflation, and unemployment, 1947-78

11.1 Market and natural rates of interest

12.1 Rate of unemployment and annual rates of change of money

and consumer prices, 1965-75

I The Old Lady of Threadneedle Street, 1797 239

IV Deliverance at Hand Ehrhart in Puck.·· 241

VIa-b Secretary of the Treasury Fred Vinson makes the case for

multilateralism in congressional hearings on the

VII Federal Reserve Board Chairman William McChesney

Martin discusses the Board's increase in the discount rate,

which President Lyndon B Johnson had criticized, at a

3.1 Bank of England Charters, 1694-1844 page 39

5.1 Bank of England Return, September, 7,1844 94 5.2 Selected Bank of England Returns, September 1846 to

Preface

I have been involved in monetary policy only remotely in groups briefing Federal Reserve Bank presidents for Federal Open Market Committee meetings, but I have had numerous opportunities to observe policymakers and their close advisors: as a graduate student at the Federal Reserve Bank of Chicago, an economist at the Federal Reserve Board, and visitor

at the Federal Reserve Banks of Philadelphia, Dallas, and Chicago It has always been clear to me - at first very disapprovingly, then less so - that central bankers do not see the world like economists Examinations of the statements and actions of earlier central bankers in Great Britain as well as the United States convinced me that this has always been so

I do not touch on the questions of whether central banks have been more harmful than beneficial or whether they ought to exist, but rather

on understanding them I hope the study will come across as a thetic inquiry by an economist into the knowledge and behavior of central bankers - into what makes them tick I give them no grades, but I hope

sympa-that a better understanding of the continuity of their behavior, while at the

same time recognizing that they are not immune to ideas, may promote a more useful interaction between them and economists

Much of the research and writing of this book took place at Clare Hall, Cambridge, with its access to the University and Marshall Libraries, and at the American Institute for Economic Research, Great Barrington, Massachusetts I am grateful to these institutions and to the above-the-call-of-duty editorial guidance and advice of Michael Bordo, Robert Hetzel, and Anna Schwartz Most of my other debts are revealed in the citations to the many excellent studies of central banking of which I am one of the fortunate inheritors

XV

ONE

Understanding Central Bankers and Monetary Policy

Our monetary system is unprecedented After decades of instability, tral bankers, governments, and economists have reached a consensus that the appropriate role of a central bank in the prevailing fiat-money regime includes: (1) the clear assignment of the responsibility for inflation to the central bank; (2) agreement that inflation should be low and stable; (3) rejection of price controls as a means of controlling inflation; and ( 4) ac-ceptance of whatever degree of fluctuation is required in interest rates to achieve the inflation objective This is at once more ambitious and more modest (realistic) than earlier systems The gold standard was a way to price stability in the long run, and Keynesian monetary and fiscal policies aspired to multiple (if inconsistent) price and quantity goals

cen-The system is not accidental This book traces its development through successive interactions of central bankers, economic ideas, and govern-ments, all affected in greater or lesser degrees by the experiences of earlier systems There are several excellent histories of central banking for par-ticular periods.1 However, this is the first attempt to tie the threads across

1 Standouts include the authorized histories of the Bank of England by John Clapham (for 1797-1914), Ralph Sayers (1890-1944) and John Fforde (1941-58) and, for the United States Richard Timberlake's history of monetary policy from Alexander Hamilton to Alan Greenspan and Milton Friedman and Anna Schwartz's Monetary History of the

T Fortune A Concise and Authentic History of the Bank of England, Thorold Rogers, The

A E Feavearyear, The Pound Sterling Marston Acres, The Bank of England from Within,

P G M Dickson, The Financial Revolution in England: A Swdy in the Development of

and David Kynaston, The Bank of England: Money, Power and Influence, 1694-1994 An

1

three centuries within a unified framework that is made up not only of monetary theory but of the situations of central bankers in the financial markets The story is told from the standpoints of central bankers in two countries, from the establishments of the Bank of England in 1694 and the Bank of the United States in 1791, although similar policy regimes in Europe and elsewhere suggest that it has wider applicability (which will

be examined in the last chapter)

The focus on central bankers has several advantages for ing the monetary system Their position at the center provides a unique perspective on the progress of events, and their responsibility for day-to-day policy gives their exchanges with governments insight into policy in practice The views of policymakers as revealed in the statements of Gov-ernors Whitmore, Harman, and Palmer before parliamentary inquiries in

understand-1810, 1832, and 1848 are not found elsewhere; nor are Governor Hankey's quarrel with the Economist's Walter Bagehot, Governor Lidderdale's re-actions to the Crisis of 1890, Governor Norman's defenses of resumption

in the 1920s, the resistance of Governors Cobbold and Cromer to ment pressures in the 1950s and 1960s, or Governor George's exposition

govern-of the new consensus in 1998.2 The institutions of American monetary policy have been more changeable, but Nicholas Biddle's defense against Andrew Jackson's war on the Second Bank of the United States and the explanations of Treasury monetary policies by Secretaries Guthrie, Sherman, and Shaw and of Federal Reserve policies by Governors Strong, Harrison, Eccles, Martin, Maisel, Burns, Volcker, and Greenspan are equally valuable Heads of Federal Reserve Banks were called gover-nors before the Banking Act of 1935 {for example, New York's Benjamin Strong and George Harrison); they were called presidents thereafter Finally, their common situation in the financial markets provides a strong element of continuity to the development of central banks We

American sample is provided by Parker Willis, The Federal Reserve System, Paul Warburg, The Federal Reserve System: Its Origin and Growth, Randolph Burgess, The Reserve Banks and the Money Market, Seymour Harris, Twenty Years of Federal Reserve Policy, E A

Goldenweiser, Federal Reserve System in Operation, Lester Chandler, Benjamin Strong, Central Banker and American Monetary Policy, 1928-41, Elm us Wicker, Federal Reserve Monetary Policy, 1917-33, and David Wheelock, The Strategy and Consistency of Federal Reserve Monetary Policy,/924-33 Although Alan Meltzer's history ofthe Federal Reserve

from 1913 to 1951 did not appear until2003, many of its previously published components are used

2 Jeremiah Harman, Horsley Palmer, and Thomson Hankey were past governors on these occasions (Richard Roberts and David Kynaston, eds., The Bank of England, 1694-1994,

app 2)

Understanding Central Bankers and Monetary Policy 3

will see how central bankers' concern for financial stability has become reconciled with monetary policy Technology has developed, but the fun-damental characters of money and the credit markets, as well as of rep-utation and speculation, persist Central bankers' earliest and longest experiences were within the framework of the gold standard, but their intellectual positions have been similar under paper standards

Instead of treating monetary episodes as distinct, I examine policy as

a sequence of actions by durable groups with shared experiences and vironments In the 18th century, the Bank of England- the model central bank (although its directors had to be told at the end of the century that this is what they had become)- focused on profits and survival, the latter requiring the payment of gold on demand for its notes The long 19th cen-tury- unti11914- saw the progress of the Bank's acceptance of a wider responsibility for financial stability, although convertibility remained in ascendance The United States had no institution that could be called a central bank- except two short-lived Banks of the United States between

en-1791 and 1836- before the establishment of the Federal Reserve in 1913 Nevertheless, the federal Treasury Department, central money markets, and clearinghouses performed central banking functions that were gov-erned by the same ideas that prevailed across the Atlantic, that is, profits for private institutions and seigniorage for the government, subject to currency convertibility and with attention to financial stability

Central bankers failed to cope with the disruptions of World War I and the Great Depression of the 1930s and tended to make matters worse as the old system collapsed Monetary theory and practice since that time have to a large extent been quests for an adequate replacement of the pre-1914 system The dollar-exchange system that was agreed at Bretton Woods in 1944 to achieve the solidity of the gold standard without its rigidity proved inconsistent with concurrent monetary stimulations, and its breakdown in the 1970s presaged an agonizing period of accelerating inflation and unemployment

The anti-inflationary monetarist policies associated with Federal serve Chairman Paul Volcker and Prime Minister Margaret Thatcher may be understood as reactions to inflations that had failed to bring the promised benefits, and monetary debates since 1979 have led to the con-sensus just described Commitments to the new policy were legalized in the Bank of England Act of 1998 and, less formally in the United States,

Re-by the statement of Chairmen Volcker that "price stability is to be treasured and enshrined as the prime policy priority; that objective is inextricably part of a broader concern about the basic stability of the

financial and economic system" and that of Chairman Greenspan, who stipulates, "Monetary policy basically is a single tool and you can only implement one goal consistently "3

Nonetheless, we must pay attention to Greenspan's warnings of tional exuberance in the stock market," as well as his worries of a shift

"irra-in bankers' attitudes toward risk dur"irra-ing the 1998 Asian f"irra-inancial crisis:

"If there was a dime to turn on," they did, he said A "fear-induced chological response is provoking a sudden rush to liquidity that poses a threat to world economic growth When human beings are confronted with uncertainty they disengage." Comparing investors to a pedestrian crossing the street, he observed, "When you're uncertain as to whether

psy-a cpsy-ar is coming, you stop.'"'

Economists have been critical of central bankers' attention to the nancial markets at the expense of their macroeconomic responsibilities Allan Meltzer was in the tradition of David Ricardo when he told a con-gressional committee in 1964 that the Federal Reserve's "knowledge of the monetary process is woefully inadequate, dominated by extremely short-run week-to-week, day-to-day, or hour-to-hour events in the money and credit markets [T]heir viewpoint is frequently that of a banker rather than that of a regulating authority for the monetary system and the economy "5

fi-Notwithstanding these criticisms, we will learn how central bankers' understanding of their role in monetary policy has grown The stage for the intellectual gap between the two groups is set in Chapter 2, which examines the Bank of England's denial of the Bullion Committee's charge

of economy-wide effects of what the Bank saw as normal lending practices Its rejection of the risks and responsibilities of managing the currency was the occasion of Ricardo's censure that opens the book We will encounter more instances of this difference in viewpoint, but jumping ahead to 1998,

we see that the conflict between the career central bankers and economists

on the Bank's Monetary Policy Committee (MPC) was similar to that between the Bank and the economists on the 1810 Bullion Committee According to the Monetary Policy Committee's minutes, although the staffs economic model recommended a rise in the Bank's interest rate, Bank careerists favored "delaying any rise in interest rates, even if a rise

3 Forrest Capie et al., eds., The Future of Central Banking, pp 258, 343

Domestic Finance of the Committee on Banking and Currency, 88th Cong., 2nd sess., Feb 11, 1964,pp.927,932

Understanding Central Bankers and Monetary Policy 5

were necessary.'~ They referred to "unusually large" near-term tainties and did not "feel very confident about the outlook and it would not necessarily be right to draw policy conclusions mechanically from the [staff's] projection In these circumstances there was a case for delay so as

uncer-to allow judgment uncer-to be made later in the light of more information." If the downturn proved sharper than expected, an increase in interest rates might have a severe negative effect on output, "and would have to be quickly reversed Such a reversal could impair confidence in the econ-omy" and create "confusion about monetary policy There was thus a strong case for waiting to get a clearer impression of the extent of the slowdown in the economy before taking policy action "7

This thinking was like that of the Bank directors in 1819, who protested Ricardo's money rule as "fraught with very great uncertainty and risk"

in which "discretionary power is to be taken away from the Bank," and might, because of the impossibility of deciding "beforehand what shall be the course of events," impose "an unrelenting continuance of pecuniary pressures upon the commercial world of which it is impossible for them either to foresee or estimate the consequences."

The 1998 Committee's academic economists opposed this position by arguing that "policy should reflect the latest news and that uncertainty in itself was no reason for delay." They believed that to delay decisions tore-duce the risks of reversal was "irrational." "So long as any policy reversals could be properly explained by new developments or improved analysis of the outlook, they need not create confusion about policy [T]he desire

to minimise the risk of policy reversals was likely to mean that interest rate changes would, on average, be made too late." The tie vote was broken

by Governor George in favor of waiting

Economists have found it "difficult to rationalize" central bankers' concern for smooth interest rates and short-term stability in the financial markets.8 Nonetheless, they must take it into account Central bankers cannot help behaving like bankers at least part of the time Rules are incomplete, and if economists hope to explain and influence the conduct

6 Those with histories as primarily academic economists on the Monetary Policy tee were Sir Alan Budd, Professors Willem Buiter and Charles Goodhart, and Deputy Governor Mervyn King; those with careers at the Bank or in industry were Gover- nor Edward George, Deputy Governor Ian Plenderleith, David Clementi, and DeAnne Julius

Commit-7 This and the next paragraph are from MPC minutes for February and May 1998, Bank of England, Inflation Report, May and August 1998

!! Lars Svensson, "What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules."

of monetary policy, they need to try to understand central bankers on their own ground Central bankers are informed parties to the new con-sensus, but monetary policy results from the interplay of central bankers' pragmatism with economists' ideas and the wishes of governments The latter- the ultimate authority- cannot be ignored The freedoms that central banks have been given can be taken away Past government attitudes toward central banks have depended on their need for them The end of war (and government pressure for cheap finance) brought an increase in the Bank of England's independence in 1833 similar to that given in 1998 President Jackson's veto of the renewal of the charter of the Bank of the United States in 1832 was influenced by the approaching end of the national debt Senator Thomas Hart Benton declared, "The war made the Bank; peace will unmake it •/J

The greater independence of the Federal Reserve after the collapse

of the Soviet Union might have reflected the government's diminished need for finance as much as the public's revulsion to inflation and disillu-sionment with the Phillips Curve By the same token, the deficits arising from the War on Terror will bring pressure for monetization In any case, monetary policy is at bottom a political decision

Legislatures have also paid attention to central banks in peacetime, especially during the periods of price instability following wars, during the Great Depression, and in the 1970s Monetary standards are decided

by governments The creation of the International Monetary Fund in

1944 and its rejection by President Nixon in 1971 were not unusual in the minimal roles played by the central bank Wartime suspensions, de-valuations, gold standard acts, and the creation of the Federal Reserve were political decisions The task of central bankers even at the height of

"independence" is the daily conduct of policy within the framework set

by government

Governments have taken direct control of monetary policy when they lost confidence in central banks Their institutional shells remained, but monetary control was transferred in the early 1930s to the 1reasury in both countries The Federal Reserve regained control in 1951 when pub-lic opinion and Congress determined that the president had abused his monetary powers, a victory that had to be won again in 1979 The Bank

of England, although possessing advisory influence, did not approach its former powers until the 1990s

lJ U.S Senate, February 2, 1831; Herman Krooss, Documentary History of Banking and

Understanding Central Bankers and Monetary Policy 7

The last chapter surveys the present and speculates about the future of central banking The current consensus rests on an understanding, devel-oped over many years of hard experience, of what monetary policy can

do Central bankers apparently understand their assignment, although history shows that they also take the financial markets and political pres-sures seriously Nevertheless, if we accept the goal of low inflation in free markets, with the understanding that this is the best that monetary policy can do, central bankers will be able to adjust to unusual events in ways that substantially deliver the goal while smoothing the financial markets-such as when the Federal Reserve supplied liquidity after the 1987 stock market crash, during the run-up to the millennium, and after 9/11, and also when it tries to soften the impact of monetary policy on the money markets by improving its transparency.10

111 Such cases include the asymmetric directive and the promise in August 2003 oflow interest rates "for a considerable period"; Daniel Thornton and David Wheelock, "A History of the Asymmetric Policy Directive," and Richard Anderson and Daniel Thornton, "The FOMC's ·considerable Period'."

An Introduction to Central Bankers

Do you consider the amount of Bank of England notes during the last year

to have borne nearly the same proportion to the occasions of the public as

in former times? - The same proportion exactly

When you represent the quantity of Bank of England notes to be now only proportionate, as heretofore, to the occasions of the public, do you take into consideration the increased price of all articles and the consequent increase of the amount of payments; and do you assume that the quantity

of notes ought to be increased in proportion to that increase of the amount

of payments? - The Bank never force a note into circulation, and there will not remain a note in circulation more than the immediate wants of the public require; for no banker, I presume, will keep a larger stock of [the Bank's] notes by him than his immediate payments require, as he can at all times procure them

[Question repeated]- I have taken into consideration not only the creased price of all articles, but the increased demands upon us from other causes

in-Minutes of Evidence, Bullion Committee, testimony of Governor

John Whitmore, Bank of England, March 6, 1810

So went the opening exchange between the House of Commons' Select Committee on the High Price of Gold (Bullion Committee), with Francis Horner in the Chair, and the Bank of England, represented by Governor Whitmore This testimony played an important part in the beginnings

of modern monetary theory and the intellectual discovery of central banking Economists contended that the latter - monetary policy -properly derives from the former, while the central bankers resisted The events surrounding the inflation that led to Parliament's enquiry are presented in the first section in this chapter, followed by a review of the

8

An Introduction to Central Bankers

Background: People and Events 1793: Beginning of the French Wars; financial panic

1797: Suspension of convertibility

1799: Income tax introduced

1805: Austerlitz and Trafalgar; Napoleon supreme on land, England at sea 1808: Wellington's Peninsular campaign begins

1810: Bullion Committee; resolutions voted on, May 1811

1812: Napoleon invades Russia

1814: Napoleon abdicates, retires to Elba; Congress of Vienna

1815: Waterloo

Chancellor of Prime Minister the Exchequer Political Parties

1806 Lord Grenville Lord Henry Petty between the Whig

9

1807 Duke of Portland Spencer Perceval dominance under the first

1812 Earl of Liverpool Nicholas Vansittart resurgence in the 1830s

Committee's proceedings Its members stressed in a modern way the fects of an unrestrained central bank on inflation through money creation

ef-In an equally modern way, the Bank's representatives denied bility and pointed to other causes

responsi-The third section puts the debate into a longer term perspective

by means of the best contemporary analyses of central banks Henry Thornton explained in Smithian terms that there was much to be gained from a private central bank acting in the enlightened pursuit of its inter-ests Alexander Hamilton's discussion indicates that similar forces and ideas were at work on the other side of the Atlantic, and prefaces the appearance of American central banking in Chapter 6 The last section reviews the Bank directors' second thoughts about their responsibilities after a change in political circumstances

War, Inflation, Suspension, and More Inflation, 1793-1810 The Bullion Committee was appointed on a motion by Horner on Febru-ary 1, 1810, after two years of accelerating inflation, an adverse balance

of trade, and a falling exchange rate Horner, Henry Thornton, and ers, although by no means the majority of the House of Commons, at-tributed these events to an excess of lending by the Bank of England made possible by the suspension in 1797 of its obligation, even its free-dom, to redeem its notes for gold War brought a growing public deficit

oth-as the government woth-as slow to find revenue to match its increoth-ased ing The Bank had complained of the government's pressure for funds since 1794 That pressure slackened in 1795 and 1796, but the restora-tion of gold convertibility in France and uncertainty of British inten-tions sparked a decline in the Bank's gold reserve from £6 million in February 1795 to £1 million in February 1797 When the drain was turned to panic by rumors of a French invasion and the Bank informed Chancellor of the Exchequer (and Prime Minister) William Pitt that its situation was desperate, he called a Council of State, which declared on February 26

spend-that it is indispensably necessary for the public service spend-that the Directors of the Bank of England should forbear issuing any cash in payment until the sense

of Parliament can be taken on that subject and the proper measures adopted thereupon for maintaining the means of circulation and supporting the public and commercial credit of the kingdom at this important juncture.1

The order was confirmed by the Bank Restriction Act, passed on May 3, effective until June 24, and kept in force by continuing acts until 1821 Although the Act referred only to the Bank of England, other banks took the opportunity to refuse redemption of their notes, and before the end of the war the number of country banks had tripled.2 The public acquiesced, and the country's monetary base was transformed from gold

to Bank of England notes

Later estimates (there were no contemporary price indices) indicated average inflation of about 3 percent per annum between 1797 and 1810.3 The Bank's note and deposit liabilities grew about 6 percent per annum and the value of its notes at Hamburg, the exchange most often quoted, fell at an average rate of 2 percent.4

1 Edwin Cannan, The Paper Pound, p ix; see pp xliii-xlvi for the data referred to here

2 John Tritton of Barclay & Co estimated that the number of country banks had increased from 230 in 1797 to 721 at the time of his evidence to the Bullion Committee (April 9 1810)

~ W S Jevons, Investigations in Currency and Finance, p 144, reported in Cannan's Table I

4 The exchange rate data are from an appendix to the fourth edition of Ricardo's High Price

of Bullion, Works, iii, p 121

An Introduction to Central Bankers 11 One of the leading critics of the inflation, Walter Boyd, pointed to its underlying cause in 1801:

Indeed it is not to be supposed that a corporation whose profits chiefly arise from the circulation of its Notes, and which is exclusively directed by persons partici-pating in the profits, has been, or could possibly be, proof against the temptation which license they have enjoyed since February 1797 has afforded

Walter Boyd, A Letter to the Right Honourable William Pitt on the Influence of the Stoppage of Issues, p 4

An obstacle encountered by those - not excluding members of liament - desiring to monitor the Bank was its secrecy It issued no regular reports until compelled by the government in 1832 In Boyd's time it had partially yielded to pressure with coded versions of its balance sheets, which according to the actuary William Morgan, "would require

Par-an Oedipus to decypher them."5 Pitt told the House of Lords committee

of enquiry into the causes of the suspension that he had "received from the Bank confidentially the particulars of their precise situation, and must beg to decline stating those particulars, unless I receive their per-mission '>6 He successfully resisted a motion in the House of Commons for information on "outstanding advances made from the Directors of the Bank to the Government" on the ground that it would tend to divulge the private transactions of the Bank, and thereby prove injurious to pub-lic credit "7 (The Bank records for this period used by later students and upon which Fig 2.1 is based are from the 1832 Bank Charter Committee.) When he thought that he had found a key to the Bank's activities leading

up to the suspension, Morgan wrote,

Neither our foreign trade nor our commercial intercourse at home have derived much advantage from the operations of this bank Its chief energies have been unequivocally directed to another quarter The advances to Government have generally been four or five times greater than the private discounts [I]t must appear as if its principal purpose had been to enable a minister to lavish the public revenue much faster than it could ever be collected; and to furnish him with the means of engaging in the most extravagant and ruinous expence before his prodigality could be submitted to the deliberation of Parliament

William Morgan, ··on the Finances of the Bank"

5 On the Finances of the Bank," discussed by P Sraffa, "The 'Ingenious Calculator'," an

appendix to Ricardo's Works, iv, pp 415-16; and Judy Klein, Statistical Visions in Time

chap 4

6 House of Lords, 1797, p 7

7 Frank Fetter, Development of British Monetary Orthodoxy 1797-1875, p 61

Neither the Bank nor the government admitted responsibility for the inflation, but an income tax and then the Peace of Amiens (1802-3) brought a respite.8 The deficit was still substantial, but the government turned to the capital market In 1808, the Bank's liabilities were only

20 percent more than in 1801 and were almost unchanged from 1805 Prices and exchange rates had stabilized, the Bank's stock of gold was replenished, and its notes were exchanged for gold at par Convertibili-

ty might have been resumed with little difficulty "But no Government involved in a great war is willing to give up so potent an engine for sur-reptitiously fleecing its subjects as an inconvertible currency, whether in its own hands or in that of a bank which it influences," the sound-money Edwin Cannan wrote in 1919 during another suspension.9

The year 1809 saw renewed inflation, most strikingly revealed in the price of gold In his first appearance in print, Ricardo observed,10 The mint price of gold is 77 7/8 shillings and the market price has been gradually increasing, and was within these two or three weeks as high as 93s per ounce, not much less than 20 per cent advance

David Ricardo, Morning Chronicle, August 29, 1809 11 The price of Bank notes per ounce of gold (par of £3 17s 10V2d) paid

by the mint before suspension is converted to shillings We will be helped

by definitions of the coins and related terms that were used in the bullion debate Until decimalization in 1971, the pound consisted of 20 shillings

of 12 pence each (denoted d from the Roman denarius.) The English pound, like Charlemagne's livre, was originally a troy (after the French city of Troyes) pound of 12 ounces or 240 pennyweights of silver The principal gold coin at the time of suspension was the guinea, which had been minted since 1663 with an elephant, the mark of the African com-pany that supplied it An increase in the market price of gold had raised its effective exchange value to 21 shillings The guinea was replaced by the gold sovereign, worth 20 shillings, in 1817, although many professional

x An income tax was introduced in 1799, repealed and reintroduced with the beginning and end of the Peace of Amiens in 1802 and 1803, repealed in 1816, and reintroduced permanently in 1842 (Roy Douglas, Taxation in Britain since 1660, pp 40-52)

IJ Cannan, op cit., p xviii

a Quaker had estranged them from their families; conversion to the Church of England enabled him to serve in Parliament from 1819 to 1823; he retired from business in 1814 to develop his economics, of which he had become the foremost authority; The Principles

11 Ricardo, Works, iii, p 17

An Introduction to Central Bankers 13

fees continued to be expressed in hypothetical guineas of21 shillings, now

£1.05.12 "Bullion" refers to bars and ingots whereas "specie" encompasses bullion and gold and silver coin Money was nominally bimetallic (gold and silver) but had become monometallic (gold) in practice, confirmed

by statute on the resumption of convertibility in 1821

In an application of the quantity theory of money, Ricardo contended that the high price of gold was evidence of a general increase in commod-ity prices caused by the over issue of Bank notes The suspension stim-ulated the premier theoretical controversy in the history of money The participants were able to use the 18th-century contributions of Richard Cantillon, David Hume, and Adam Smith, although Ricardo and the Bul-lion Committee may with justice be called the founders of the monetary theory that became part of the Ricardian classical system.13 They are made even more luminous in monetary histories by their victory over the Bank directors- intellectual victory, that is, because Parliament voted its preference for the Bank's principles over the Bullion Committee's The directors' statements showed an ignorance of the relations among money, prices, interest rates, exchange rates, and the balance of trade that was shocking in men possessing great influence over them Walter Bagehot later called their testimony 44

almost classical by its nonsense "14

I argue that this view of the directors, although correct as far as it goes,

is incomplete It is limited to what they did not know, namely the wider, macroeconomic effects of their actions, and neglects what they knew best, and felt most- the financial markets The Bullion Committee's questions and the Bank's answers, if so they may be called, hardly represented an exchange of views and certainly were not an argument The two sides oc-cupied different levels: Macroeconomic questions elicited microeconomic responses

A primary contention of this study is that the language and decisions

of the directors closely resembled those of later central bankers, which was almost inevitable in view of their common backgrounds and situa-tions If one's beliefs and actions are conditioned as much by experience and environment as by abstract arguments, we should not be surprised that central bankers talk and act like bankers Most of them have been

12 A E Feavearyear, The Pound Sterling, pp 90, 142, 198

13 Cantillon Essay oil the NatureofTradein General; Hume, "Of Money" and other Writings

is by Jacob Viner, Studies in the Theory of International Trade chaps 1 and 2

14 Walter Bagehot, Lombard Street, p 167

bankers, and they operate in a bankers' milieu They are slow to see why the practices that have worked in one institution may not apply in another The Bank of England was to the directors just a large bank, with a spe-cial responsibility for financial stability because of its size (and they were not always conscientious in this regard, another reflection of bankers' behavior) but none for such macroeconomic variables as the price level The directorships were part time, and the governor and deputy gover-nor, who served in each capacity for two years, were short-term central bankers, hardly separated from their own banking and trading houses

We will see in later chapters that their views of economic relationships have been shared by their successors at the Bank and the Federal Reserve

The Bullion Committee and the Macroeconomic

Responsibilities of the Bank of England The early witnesses before the Bullion Committee- brokers and dealers in gold and merchants in foreign trade- established the state of the currency There had been a quiet period in the middle of the decade, but the gold market had been active since 1808, and the price exceeded 90s when the Committee met in 1810 The rate of exchange on Hamburg (34V2 before suspension) was 29 Flemish shillings per pound sterling The Committee believed that the depreciation of the currency was due to the increase in its quantity arising from the excessive credit - in government securities and private discounts- of the Bank of England The governor came prepared

to defend the Bank, which explains his premature response to the second question quoted at the beginning of the chapter Before going into the Committee's efforts to break down the Bank's argument, we look at the governor's elaboration of its position in a later appearance:

State to the Committee what is the criterion which enables the Bank at all times

to ascertain that the issue of Bank notes is kept precisely within the limits which the occasion of the public requires, and thereby to guard the circulation of this country against the possibility of any excess; and in what manner the control necessary for maintaining uniformly an exact proportion between the occasions

of the public and the issues of the Bank, is exercised and applied by the Court of Directors.- I have already stated that we never forced a Bank note into circulation, and the criterion by which I judge of the exact proportion to be maintained is by avoiding as much as possible to discount what does not appear to be legitimate mercantile paper The Bank notes would revert to us if there was any redundancy

in circulation, as no one would pay interest for a bank note that he did not want

to make use of (March 13)

An Introduction to Central Bankers 15 This rule -the limitation of loans to "real" transactions of merchants,

as opposed to speculation -applied regardless of other terms of lending:

Is it your opinion that the same security would exist against any excess in the issues of the Bank if the rate of discount were reduced from five to four percent?

Mr Whitmore -The security against an excess of issue would be, I conceive, precisely the same

Mr Pearse (deputy governor)- I concur in that answer

If it were reduced to three percent?

Mr Whitmore - I conceive there would be no difference, if our practice mained the same as now, of not forcing a note into circulation

re-Mr Pearse - I concur in that answer

However, the rule was not always applied The governor had earlier conceded (March 6) that the Bank used discretion:

Antecedently to the suspension of the cash payments of the Bank, was it not the practice of the Directors to restrain in some degree their loans or discounts in the event of their experiencing any great demand upon them for guineas [gold coins)?- The Bank always act with that prudent caution, that their advances to the public upon discount can be called in two months, or at furthest 90 days [Question repeated)- A short time antecedently to the restriction upon the Bank, they were seriously alarmed at a diminution of their coin, and did in some degree limit their advances, both to the public and to the Government I would wish to be understood, that they do now set limits to their advances according to circumstances, and as their discretion may direct them

This was a last resort, however The Bank recalled previous tions, particularly just before suspension, with regret:

applica-I perfectly well remember the Bank limiting a certain sum of discount to be made to each commercial house applying for it; that was the mode of diminishing the whole amount of discount I would also wish to add, that afterwards in the contemplation of many of the Directors, this last was a measure to be regretted under the then circumstances, on account of the very considerable embarrassment and inconvenience by it to the mercantile world

Thornton's analysis of the effects of credit restrictions will be presented

in the next section For the present, we focus on the Committee's attempt

to get the directors to admit the macroconsequences of the Bank's actions, their denials, and their concern for financial stability

On what principle is it now the practice of the Bank to regulate the general amount of their loans and discounts, and what was the principle antecedent to the restriction; namely, do they endeavour to keep the quantity of Bank of England notes nearly at their usual level, or do they enlarge their advances to merchants when the merchants happen to extend their demands for discount

[or] by a reference to the state of the exchange, and to the difference between the market price and the mint price of Gold ? -We do not comply with the demands for discounts to the extent demanded of us; it has always reference, not only to the solidity of the paper, but to the amount of the accommodation the individual applying for it already has We never discount without the circumstances being considered; namely the amount already given to the individual, the solidity of the paper, and the appearance of its being used for commercial purposes I do not advert to the circumstances of the exchanges, it appearing upon a reference

to the amount of our notes in circulation, and the course of exchange, that they frequently have no connexion

The Bank's defenders pointed to the lack of correlation between the quantity and value of the Bank's issue Figure 2.1 shows that M (money) and X (the exchange rate) moved oppositely half the time between 1797 and 1809, and between 1809 and 1821.15 Nicholas Vansittart, government spokesman on the Bullion Report and chancellor of the exchequer from

1812 to 1823, reminded the House of Commons in 1815 that the rise in

15 Similar data are in R G Hawtrey, Currency and Credit, p 283

An Introduction to Central Bankers 17

the price of gold between 1810 and 1813 had not been accompanied by

an increase in the Bank's circulation, the price fell between August 1813 and October 1814 while the circulation rose (the French armies suffered

a series of defeats beginning in June 1813, culminating in the rout of the Grand Armee at Leipzig in October), and the violent fluctuations in the year of Waterloo," Cannan added, could certainly not be attributed

to changes in the note circulation "16 Wesley Mitchell later described the sensitivity of greenbacks to military fortunes during the American Civil War: " fluctuations in the premium on gold were so much more rapid and violent than the changes in the volume of the circulating medium that not even academic economists would regard the quantity theory as

an adequate explanation of all the phenomena."17

Looking at longer term movements, we observe that the values of sterling and the dollar trended downward during periods of credit expan-sion and upward during deflations These short- and long-term deviations are reconciled by letting the demand for money depend on its expected value For example, Napoleon's defeats in 1813 improved the chances of early resumption They were explained in the testimony of a "Continental Merchant" who had observed that inconvertibility preceded the depre-ciation of currencies and that ultimate results are anticipated by the speculation of individuals" (March 5).18

The Bank would not concede that the value of money is affected by its quantity:

Supposing the currency of any country to consist altogether of specie, would that specie be affected in its value by its abundance or by its diminution, the same as copper, brass, cloth, or any other article of merchandise?- I have already said that I decline answering questions as to opinion; I am very ready to answer any questions as to matters of fact (March 13)

On his last appearance before the Committee (March 30}, the governor alternated between denying that the value of money was related to its quantity and saying that "It is a subject on which such a variety of opinions are entertained, I do not find myself competent to give a decided answer." The Bank has been accused of a mistaken belief in the real bills doc-trine, according to which price stability is assured if the quantity of money

16 Cannan, op cit., p xxvii

17 Mitchell, A History of the Greenbacks, p 188

IN Cannan conjectured that the anonymous "Continental Merchant" was Nathan schild ( op cit., p xlii), but Piero Sraffa argued that his foreign situation and other evidence pointed to John Parish of Parish & Co in Hamburg ("Mr._ of the Bullion Report")

Roth-is linked to output by tying bank lending to real transactions.19 The trine is expressed in the equation of exchange, MV = PT, where M is the average quantity of money in a period, V (velocity) is its rate of turnover,

doc-Pis the average price of transactions, and Tis the number of transactions

or money purchases of goods and services If M is linked to T, then P

is constant - if V is constant So the doctrine is qualified immediately, although this is not a concern if we want a money rule that does not itself cause price changes

The limitation of bank discounts to real bills cannot be relied on for price stability, however, because it implies no particular relationship be-tween M and T A bundle of goods might give rise to several bills of exchange with overlapping lives as it makes its way from manufacturer or importer through merchants to retailers However, even if there were pre-cisely one real bill, discounted at a bank and outstanding precisely as long

as the bundle that it finances is in the marketplace, P would be nate A unique quantity of money is not tied to a bundle of goods because the amount borrowed and lent on the security of the goods depends on the prices that the parties expect them to fetch in the market Both M and

indetermi-P depend on expected prices If inflation is expected, purchases require large loans, and the expectation is realized

These points had been made by Thornton in 1802 in An Enquiry into the Nature and Effects of the Paper Credit of Great Britain In parliamentary debates on the Bullion Committee's report, he pointed to the similarity between the Bank of England's policy and John Law's land bank that had failed a century before in France

Mr Law considered security as everything, and quantity as nothing He proposed that paper money should be supplied (he did not specify in his book at what rate

of interest) to as many borrowers as should think fit to apply, and should offer the security of land He forgot that there might be no bounds to the demand for paper; that the increasing quantity would contribute to the rise of commodities: and the rise of commodities require, and seem to justify, a still further increase.20 Thornton argued that the only way to limit money was to charge in-terest commensurate with the rate of profit that merchants expected to

I<J See, for example, the Bullion Report and Lloyd Mints, A History of Banking Theory in

Great Britain and the United States, chap 4

Paper Credit of Great Britain, p 342 Also see the discussion in Fetter, op cit., p 43 John

L1w urged the issue of money on the security of land in Money and Trade Considered

He was given an opportunity to implement his theories in France, but after a period of success they burst with the Mississippi Bubble in 1720

An Introduction to Central Bankers 19

earn on borrowed money "Whilst the Bank is willing to lend," Ricardo agreed, "borrowers will always exist, so that there can be no limit to their overissues "21

The Bullion Report condemned the Bank's behavior in words probably written by Thornton:22

(W)hile the convertibility into specie no longer exists as a check to an over issue

of paper, the Bank Directors have not perceived that the removal of that check rendered it possible that such an excess might be issued by the discount of perfectly good bills So far from perceiving this, Your Committee have shown that they maintain the contrary doctrine with the utmost confidence That this doctrine

is a very fallacious one, Your Committee cannot entertain a doubt The fallacy upon which it is founded lies in not distinguishing between an advance of capital to Merchants and an additional supply of currency to the general mass of circulating mediumP

This last sentence goes some way toward the Bank's intellectual sition, which was not that it had an incorrect theory of the price level, but that it had no theory The Committee had tried to get the direc-tors to consider the macroeconomic effects of their actions, but the latter showed no sign of comprehending even the possibility of such effects Short-term lending on good security subject to an adequate reserve is sound banking practice If we look at the Bank of England as a com-mercial bank, we find consistency and comprehensibility Its protests of innocence of wider effects are less satisfactory Nonetheless, they were consistent with a desire not to be derailed from its focus on the bank-ing business and its understanding of its limited public responsibilities that was to continue for many decades "To those who governed and worked in the Bank," Ralph Sayers wrote of the 20 years before 1914, af-ter Bagehot had tried to tell them that they were a central bank, "the daily business appeared almost entirely as the business of a bank - a slightly peculiar bank - with its select groups of customers," the first being the government

po-If there had been an articulate Governor (they do not seem to have been born that way) he might have said that fundamentally he had three duties He had a statutory duty to maintain the convertibility of the note into gold coin; he had a

21 Ricardo, Joe ci1

22 The Repor(s authors were Thornton, partner in the Downe, Free & Thornton bank, whose home was the center of the Clapham Sect that included William Wilberforce; Horner who founded the Edinburgh Review; and William Huskisson, who held several government offices in a long parliamentary career

2:l Cannan op cil., p 50

political duty to look after the financial needs of the Government; and he had a commercial duty to maintain an income for the stockholders

R S Sayers, The Bank of England, 1891-1944, pp 5, 8

The Bank's survival was threatened by government borrowing, and the Bank and Pitt had disagreed about what was excessive Private lending

is also a delicate business Banks do not like to restrict lending ers, even issuers of short-term debt, depend on finance for the long haul Commitments are made months or years in advance, and orders for goods and other financial obligations are undertaken in the expectation of reli-able credit The nonrenewal of loans is liable to bring "stoppages" even

Borrow-by solvent, though illiquid, firms One stoppage might bring another, and

in the complex fabric of finance everyone is at risk Banks are reluctant

to compensate for increased government finance by refusing their private borrowers - especially when business is brisk, borrowers appear sounder than usual, and reserves are not a problem

The Committee recommended retention of the existing commitment

to resumption within six months after the war's end, and asked for vertibility within two years if the war continued A motion to this effect was rejected by the House of Commons by a 18~5 vote The majority sided with the Bank in ascribing fluctuations in the exchange rate and the price of gold to factors other than the Bank's credit policies The House accepted the paper standard, although it resolved to terminate the sus-pension as soon as "the political and commercial relations of the country" rendered it "compatible with the public interest "24 These positions are reconciled on practical if not intellectual grounds if Parliament preferred the gold standard "in ordinary times" but would not interfere with war finance.25

con-Banking, Central con-Banking, Knowledge, and Incentives

to the Public Interest

We are all City people and connected with merchants, and nothing but merchants

on every side

24 Ibid., p xxvi

25 Loc cit

Henry Thornton on his brothers' ambitions to society2 6

26 Quoted from Recollections of Marianne Thornton by F A Hayek, "Introduction" to Thornton's Paper Credit, p 12

An Introduction to Central Bankers 21

Judgment of the Bank's conduct in the crisis of war might reasonably begin with its proper behavior in ordinary times Thornton's Paper Credit still ranks as the best combination of monetary theory and banking practice It begins: "Commercial credit may be defined to be that confidence which subsists among commercial men in respect to their mercantile affairs." This is not surprising in a banker and former merchant However, this unusually reflective "commercial man" extends the equation of "credit" and "confidence" beyond individual relationships This equation forms the foundation of an analytical system capable of explaining aggregate financial flows, interest rates, inflation, exchange rates, and- most impor-tant for our purposes - the proper conduct of a central bank Although Thornton indicated in the preface that his •'first intention" was the expo-sure of "some popular errors which related chiefly to the suspension of the cash payments of the Bank of England, and to the influence of our paper currency on the price of provisions," he had probably begun the project before the suspension.27 Certainly it transcends the problems of the government and the Bank in 1802

The elements of Keynes's liquidity-preference theory of interest pear in Thornton's discussions of the motives for holding money and the influences of changes in its quantity on interest rates, and his mechanism of adjustment to international price differences was rediscovered 120 years later as the purchasing-power-parity theory of exchange rates Later dif-ficulties would have been avoided if the proponents of the Bank Charter Act of 1844 had accepted Thornton's point (and other points, as we will see later) that bank deposits perform the same monetary functions as bank notes But Thornton's best-known contributions to monetary the-ory are his proof of the indeterminacy of prices under the real bills doc-trine, the doctrine of "forced saving" whereby inflation in combination with rigid wages compels the laborer "to consume fewer articles, though

ap-he may exercise tap-he same industry," and his explanation of inflation as a consequence of the divergence between "market" and "natural" rates of interest Almost a century later, Knut Wicksell placed this divergence at the center of academic discussions of monetary policy, and it influences the Bank of England and the Federal Reserve today

We will apply these contributions in other places Our interest in Thornton here stems from his analysis of the role of the central bank

in the financial system Because that role is derived from credit, that is,

Thornton, cit., p 67

confidence, it was necessary to pave the way for monetary policy by first explaining the origins and maintenance of confidence Most of the anal-ysis applies to any bank and implies strong parallels between the actions proper to bankers and central bankers

It is "this confidence," Thornton continued from the opening sentence,

"which disposes them to lend money to each other, to bring themselves under various pecuniary engagements by the acceptance and indorsement

of bills, and also to sell and deliver goods in consideration of an equivalent promised to be given at a subsequent period." Credit is normally mani-fested in paper - bills of exchange, bank notes, and other securities - that serves "to express that confidence which is in the mind, and to reduce to writing those engagements to pay, which might otherwise be merely ver-bal." The benefits of credit are great "The day on which it suits the British merchant to purchase and send away a large quantity of goods may not

be that on which he finds it convenient to pay for them." Without credit,

"he must always have in his hands a very large stock of money; and for the expence of keeping this fund (an expence consisting chiefly in the loss

of interest) he must be repaid in the price of the commodities in which he deals." Credit sets him "at liberty in his speculations: his judgement as to the propriety of buying or not buying, or of selling or not selling, may

be more freely exercised "28

The credits and payments of the country converged on the Bank of England Trade was financed by bills of exchange, that is, marketable obligations to pay fixed amounts at fixed times and places Buyers desiring credit accepted bills drawn on them by sellers Most bills were drawn on London That is, payments were made in London, and merchants and bankers outside London maintained connections there to handle their payments and receipts London was to the whole island, and even to Europe and perhaps the world, "what the centre of a city is to the suburbs." Although Thornton did not apply "central" to the Bank of England, he wrote that banks are

particularly likely to be multiplied in a state like ours, in which the mercantile transactions are extended, the population is great, and the expenditure of indi-viduals considerable; and also where a principal bank exists, which through the necessity imposed on it by its situation undertakes the task of providing a constant reservoir of gold accessible to every smaller banking establishment The creation

of the large bank operates as a premium on the institution of the smaller

Thornton, Paper Credit, pp 168-69 2K Ibid • p 77

An Introduction to Central Bankers 23

The gold reserve had to be available Because it was concentrated

in the Bank, that institution had to be ready to pay it on demand This sometimes entailed the conversion of its note and deposit obligations into coin or bullion, but more often it meant the willingness to supply its notes, which were regarded "as good as gold," that is, to lend "The practice had grown up," Ralph Hawtrey wrote, "of the Bank of England acting as the lender of last resort"- the "dernier resort" as Francis Baring called it in

1797.29 Hawtrey writes,

[I]f there was a general shortage of cash, so that the sellers of bills in the market predominated over the buyers, there was no way of providing for the unsold residue of bills unless the Bank of England would take them ; it was expected

to discount all eligible bills offered, whether by merchants or by bankers, and any bills on London maturing within ninety-five days and bearing two good English names (one being the acceptor) was eligible

Hawtrey, A Century of Bank Rate, p 11 The central bank's ability and willingness to satisfy these demands in times of crisis was, with the question of the standard, one of the two main issues of monetary policy in the 19th century Attention to Thornton's ex-planation of the importance of maintaining the Bank's circulation would have benefited many future central bankers and legislators:

It has been shewn already that in order to effect the vast and accustomed payments daily made in London, payments which are most of them promised beforehand,

a circulating sum in bank notes nearly equal to whatever may have been its tomary amount is necessary But a much more clear idea of this subject will be gained by entering into some detail

cus-There are in London between sixty and seventy bankers, and it is almost tirely through them that the larger payments of London are effected The notes

en-in their hands form, probably, a very large proportion of the whole circulaten-ing notes in the metropolis [A] very small proportion of Bank of England notes cir- culate far from London, and that it is to the metropolis itself that all the larger ones are confined The amount of the bank notes in the hands of each banker,

of course, fluctuates considerably; but the amount in the hands of all probably varies very little; and this amount cannot be much diminished consistently with their ideas of what is necessary to the punctuality of their payments and to the complete security of their houses Thus there is little room for reduction as to the whole of that larger part of the notes of the Bank of England which is in the hands

of the London bankers: the notes which may chance to circulate among other sons, especially among persons carrying on any commerce, if we suppose the usual punctuality of payments to be maintained, and the ordinary system of effecting them to proceed, can admit also of little diminution A large proportion of the

per-29 Observations on the Establishment of tire Bank of England p 20